NGC system operator incentive scheme from 1 April 2003 – 31 March 2004 Final Proposals and Statutory Licence Consultation March 2003 16/03 Summary This document sets out Ofgem’s Final Proposals for National Grid Company plc’s (“NGC”) System Operator (“SO”) incentive scheme to apply from 1 April 2003 to 31 March 2004 and also includes the accompanying statutory notice of proposals for modification to NGC’s electricity transmission licence1. NGC’s existing SO incentive scheme was introduced on 1 April 2002 to run until 31 March 2003. Therefore, a new incentive scheme needs to be put in place from 1 April 2003. Given the consultation period required by section 11 of the Electricity Act 1989, this means that the proposed licence modification, when introduced, will have retrospective effect and will apply from 1 April 2003 regardless of the date on which the Authority direction to modify NGC’s licence is made. The past SO incentive schemes, which have been primarily targeted at NGC’s external costs of operating the existing transmission system and balancing overall supply and demand (i.e. the costs to NGC of purchasing balancing services from generators, suppliers and large customers), have delivered substantial benefits over time. Between 1994 (when the first incentive scheme was introduced) and 2001, NGC reduced the annual costs of system operation by more than £400 million. Over the course of the first external SO incentive scheme under the New Electricity Trading Arrangements (NETA) from 27 March 2001 to 31 March 2002, NGC substantially reduced the level of SO costs. As a result of NGC’s performance during the first incentive scheme under NETA, Ofgem was able to reduce the target for the current external SO incentive scheme for the period 1 April 2002 to 31 March 2003 by approximately £25 million. NGC is on target to have significantly reduced costs below this lower target level for 2002/03. Initial Proposals In the Initial Proposals document2, Ofgem suggested extending the scope of NGC’s incentive scheme to cover not only its operation of the transmission system, but also the development of the transmission system (so called “deep” incentives). A deep SO incentive scheme would provide NGC with appropriate commercial incentives to respond to signals from market participants concerning their requirement for 1 Appendix 1 contains a statutory notice in respect of the licence modifications. Appendix 2 provides a marked-up version of the proposed licence modifications. 2 ‘NGC system operator incentive schemes from April 2003, Initial proposals’, Ofgem, December 2002. transmission capacity and encourage efficient and timely development of the transmission system. Ofgem called this a transmission capacity release incentive scheme. Ofgem considered that these arrangements would extend and complement the current “shallow” incentive scheme for NGC and enhance security of supply and Ofgem proposed a phased approach to introducing the new deep incentive scheme. Phase 1 (1 April 2003 – 30 September 2003) Ofgem proposed to implement a revised shallow incentive scheme for a further 6 month period (1 April 2003 to 30 September 2003). Under the proposals, NGC would be given a specific target representing a reasonable ex-ante expectation of the external balancing costs throughout the duration of the incentive scheme, based on analysis of NGC’s historic costs since the introduction of NETA and NGC’s forecast of costs (with some adjustments by Ofgem). If NGC’s balancing costs were below the target, it would keep a proportion (set by the upside sharing factor) of the reduction in costs as an incentive payment. Conversely, if its balancing costs were above the target, NGC would be charged a proportion (set by the downside sharing factor) of the costs in excess of the target. NGC’s overall gains or losses on its balancing costs would be limited by applying a cap on payments and a floor on losses. The annual parameters on which it was proposed that the 6 month scheme should be based, and the 2002/03 parameters, are shown in the table below. Ofgem’s Initial Proposals options, based on NGC’s cost forecasts, for the SO incentive scheme from 1 April 2003 to 30 September 2003 (money of the day, annualised basis) 2003/04 Parameter 2002/03 Option 1 Option 2 Option 3 Target £460 million Between £376 million and £436 million Upside sharing factor 60% 50% 50% 55% Downside sharing factor 50% 50% 50% 55% Cap £60 million £50 million £40 million £50 million Floor -£45 million -£50 million -£40 million -£50 million Ofgem proposed that the monetary parameters (target, cap and floor) for the 6 month scheme should be set to be 45 per cent of the annual figures shown above, based on historic seasonal cost patterns. The proposed scheme was to be 6 months in duration to allow time for a revised regime for the sale of transmission capacity to be developed, including the sale of longer-term rights. Ofgem considers that these are a necessary pre-requisite for the introduction of deep incentives, since the new incentive scheme would be designed to encourage NGC to respond promptly and efficiently to the signals of participants’ requirements resulting from offering these longer-term rights for sale and develop the transmission system accordingly. Ofgem additionally proposed introducing a new licence obligation on NGC to use all reasonable endeavours to develop the necessary transmission regime by October 2003, and asked NGC to review certain aspects of its connections charging methodology. Phase 2 (from 1 October 2003) On the assumption that revised transmission arrangements had been developed by October 2003 to enable firm tradable transmission capacity rights to be allocated for the period October 2003 to March 2006, Ofgem proposed that a revised shallow incentive scheme covering the same time period (i.e. 2 ½ years from 1 October 2003 to 31 March 2006) should be put in place. In addition, the introduction of contractually firm rights would mean that NGC would be required to buy-back any transmission capacity rights that it had sold but which the owners were not able to use on the day, due to constraints on the transmission system. Ofgem therefore proposed that a SO transmission capacity buy-back incentive should also be put in place covering the same period. Additionally, Ofgem proposed the introduction of a rolling 5-year SO transmission capacity release incentive by 1 April 2004 at the latest. Final Proposals The Final Proposals outlined in this document relate to Phase 1 of the NGC SO incentive arrangements from 1 April 2003. Most respondents to the Initial Proposals supported the extension of the present shallow SO balancing incentive scheme. Respondents additionally supported putting in place a shallow scheme for one year rather than the 6 month scheme proposed by Ofgem. This was due, in particular, to the view that more time was needed to consider reforms to transmission access arrangements. NGC continued to support a longer-term deep SO incentive but considered that such arrangements could be implemented without any extensive changes to the transmission access regime, other than those already brought forward (CUSC Amendment Proposal CAP043: “Transmission Access – Definition”).3 3 Alternative Amendment CAP043 was approved on 6 February 2003 with effect from 1 April 2003. Ofgem has carefully considered the views of respondents and NGC in developing the Final Proposals. Ofgem now considers that, in light of respondents’ views, the incentive scheme should be in place for one year rather than six months. Consequently, Ofgem’s final proposal is that the Phase 1 SO incentive scheme should apply for the period 1 April 2003 to 31 March 2004. Additionally, Ofgem initially considered, given NGC’s initial forecast of its balancing costs for 2003/04 and respondents’ views to the Initial Proposals, that a target in the middle of the £376 million to £436 million range consulted upon would be appropriate. However, in February 2003 NGC provided Ofgem with new information, which it believed needed to be considered by Ofgem before setting any incentive target. In particular, NGC argued that, though its forecast for overall 2002/03 outturn costs remains at around £404 million, the plant margin for 2003/04 is likely to be approximately 1.8 GW lower than it had assumed in its original November 2002 forecast. Of this reduction, 1.1 GW arises from an increase in NGC’s forecast peak demand4 and the remainder is attributed to additional plant closures and mothballing. As a result of this decrease in plant margin, NGC argued that it would have to contract for additional volumes of reserve (compared with its original November 2002 forecast) to secure the necessary operating margin. NGC translated the increase in operating margin associated with the change in plant margin into an increase in incentivised balancing costs of between £5 million and £22 million, depending on the scenario being considered. In light of Ofgem’s and NGC’s statutory duties in relation to security of supply and NGC’s position as system operator, Ofgem has carefully considered NGC’s new submission and has concluded, based on NGC’s latest information, that the plant margin is likely to be lower than NGC originally forecast and, as such, a higher level of reserve holdings is justified. Ofgem’s Final Proposals for NGC’s Phase 1 SO incentive scheme are shown in the table below. The target value effectively corresponds to the middle of the range presented in the Initial Proposals, but revised to take account of the increase in reserve associated with a tighter plant margin. 4 This refers to ‘restricted’ average cold spell demand, i.e. weather corrected peak demand net of any notified load management. Ofgem’s Final Proposals for the SO incentive scheme from 1 April 2003 to 31 March 2004 (money of the day) Parameter 2002/03 2003/04 Target £460 million £416 million Upside sharing factor 60% 50% Downside sharing factor 50% 50% Cap £60 million £40 million Floor -£45 million -£40 million Overall, Ofgem considers that the parameters of the incentive scheme provide NGC with an appropriate balance of risk and reward which is in the interest of consumers, who ultimately pay for the costs of system operation.